Rating system undergoes star review Mutual funds

Mutual funds

No mark of distinction is more sought after in the mutual fund business than a five-star rating by Morningstar, the Chicago-based mutual fund research firm.

Although Morningstar officials continually insist that their rating system of one to five stars is not intended to predict future performance, the prominent use in mutual fund advertising clearly carries that implication.

The success of the Morningstar system in becoming an investor guide to buying mutual funds naturally has drawn critics, who over the years have faulted the system for various reasons.

Morningstar says it welcomes the critiques and occasionally adjusts its system in response. Morningstar's openness to its valuation process carries an important message for investors: A rating of mutual funds is only as good as the subjective assumptions behind it, and the assumptions may not be useful to you.

The latest critical review comes from Marshall Blume of the finance department at the University of Pennsylvania's Wharton School. His well-thought-out paper is titled "An Anatomy of Morningstar Ratings."

Using an intricate statistical analysis of the system and recent results, Blume draws three principal conclusions:

Diversified domestic equity funds win more four- and five-star ratings than other types of domestic funds.

Younger funds tend to receive more top ratings than older funds.

No-load funds tend to get more top ratings than load funds sold by brokers.

Don Phillips, president of Morningstar, does not dispute the accuracy of the findings. But he makes some distinctions that investors should consider when they see the ratings blaring from mutual fund company ads.

"There are some constructive points [in Blume's research] that we take seriously and think we can build upon and a couple of other points that frankly we find a little bit silly," he said.

Phillips concurs in Blume's finding of a ratings bias against a few older funds. Blume found that in assigning its overall star rating -- the rating most widely used in mutual fund ads -- Morningstar's method of averaging the ratings for three-year, five-year and 10-year performance periods favors younger funds.

"I think that's his best point, and frankly it's something we hadn't thought about as extensively as he has," Phillips said. "It was somewhat eye-opening."

As a result, he expects Morningstar to raise the star ratings of about 12 funds with track records of 10 years or more -- out of about 1,480 funds that old and 8,800 funds overall. Other studies suggest that younger funds tend to outperform older funds.

Phillips is less impressed by Blume's other two points.

The evolution of the Morningstar rating system has emphasized the importance of long-term, diversified, low-risk and low-cost mutual fund investing, he notes.

It comes as no surprise, therefore, that no-load diversified domestic equity funds -- the funds with the characteristics that Morningstar prizes -- have relatively more five-star ratings.

"He says the problem is [the system] tends to lead people to more diversified funds, rather than more volatile, focused funds. That's not the worst of sins," Phillips said.

Yet investors who are intent on owning less diversified funds, such as technology sector funds or precious metals funds, should be aware that a low Morningstar rating for those funds may not be useful information to them.

Phillips admits to such a bias. Morningstar attempts to award five stars to 10 percent of the funds within four broadly defined classifications, such as domestic equity funds.

If the stars were awarded to more precisely drawn categories -- precious metals funds, for example -- then 10 percent of such smaller categories would receive five stars.

Given their dismal performance over many years, Phillips asked, "Should any precious metals funds get five stars?" He notes that Morningstar separately provides performance ratings of funds within more narrow investment categories.

"The ratings are cost-adjusted," he said. "Load funds in the aggregate haven't compensated for their additional costs with superior performance."

Phillips notes that the ratings are also adjusted for risk, defined as volatility of returns: "If [Blume] had dug deeper, he would have found that funds with lower risk do well in our system."

Once again, though, many long-term investors who perceive value in paying brokerage sales commissions, called loads, or who are willing to trade short-term volatility for higher long-term returns should be aware that the assumptions in the Morningstar star system may be biased against their interests.

"We steer people toward more diversified funds -- probably a responsible thing to have done," Phillips said. "And we've forced people to consider costs and risk."